There's always a way to tell a thoroughly regulated industry: when it comes time for reforms to be promulgated, the only ones that get through the sieve deal with technicalities and minutiae. At least, that's the way it appears on the outside. The reason it does so is because of what's already inside.

Knowledge of existing regulation is a kind of intellectual capital in those environs, and is also a kind of competency test. The latter point explains why reforms are made at the margin. Anyone who hopes to be taken seriously has to know and understand what's already been implemented; doing so all-but impels reforms to be adjustments of the existing corpus.

The process isn't as alien as it seems. To those who have spent years promulgating, studying, living under or using those regulations, a "start from scratch" approach is regarded in a similar manner as working mathematicians would regard a "start from scratch" approach to mathematics. All specialists in a thriving field, no matter what the field, regard a start-from-scratch approach as reinventing the wheel (at best.) The only difference between government regulations and a technical specialty, from this perspective, is that there's a certain attention paid to the plain citizen who thinks in start-from-scratch terms. That's because plain citizens are voters, and can influence the top bosses. Or, at least, they did.

Admittedly, there are some fiefdoms that treat the average Joe as if he were merely clueless. Such bureaus are an unfunny answer to the British comedy Yes, Minister. In America, at least, they tend not to be populated by witty and charming obfuscers. Their heavyweights tend to be pedants whose knowledge and experience have crowded out their common sense.

Financial-institution regulation may be part of this category; the widespread anger suggests it. But it may not be, or at least may not inflexibly be. So, I introduce the sledgehammer for consideration.

The Sledgehammer: 100% Reserves On Demand Deposits

We know that there are a lot of excess bank reserves. There have been some fears that today's excess reserves are like those in the 1930s, but money supply growth assuages that fear. M1, until recently, was growing at a fast clip. M2 has been growing more modestly but hasn't shrunk. The monetary situation in the U.S. is unlike that of the early 1930s because there's been no evaporation of the money supply. It isn't like that of the late '30s because the late '30s were a product of the early '30s.

Required reserves are $63.170 billion. Total reserves are $1,126.563 billion. Excess reserves are $1,063.393 billion. [Data from here.] Virtually all U.S. bank reserves are excess.

The reason why is because the Fed's been creating a ton of reserves to serve as a capital buffer for member banks. Given that lending on those reserves as per normal procedure would produce very serious inflation. Given that the present excess is accompanied by near-price stability slightly on the inflationary side, those excess reserves might as well be required reserves. There's a certain stability in that excess.

That stability leads to an eye-opening question: why should those excess reserves be excess? Why not convert them to required reserves?

The United States monetary system, thanks to the Fed part of the bailouts, is in a historically unique situation – one first perceived by Lucas M. Engelhardt back in December of 2008. Excess reserves are $1,063.393 billion. The M1 money supply is currently $1,665 billion. The currency component of M1 is $860.9 billion. Thus, the total amount of demand deposits is $804.1 billion. [M1 and component data is found here.]

For the first time in postwar history, if not for the first time in history, Federal Reserve System member banks' reserves – money that's safe and available on demand – is more than total member banks' demand-deposit liabilities. The Fed, or the law, could mandate banks to back up their demand deposits with 100% reserves and excess reserves would still be in the system. As of the most recent figures, current reserves are more than $200 billion greater than total demand deposits. Of those reserves, only $125.3 billion are borrowed. The amount of free-and-clear excess reserves, in the aggregate, is in excess of aggregate demand deposits. For the first time in postwar history, demand deposits could be fully covered in the aggregate by reserves without any downward pressure being put on the money supply at all. There would be no need to any bank to deleverage because there'd still be excess even after such a policy was enacted. If anything, there'd be room to ramp up lending a little. That's what excess reserves allow for.

In nuts and bolts, a 100% reserve policy on demand deposits means that there's a dollar deposited in the Fed for every dollar in a demand-deposit account. Every cent in demand-deposit accounts is covered by reserves that can be turned into currency if needed. What this means, in practical terms, is that bank failure would not hurt the owners of demand-deposit accounts. Only time-deposit accounts would be at risk.

With respect to the nuts-and-bolts of monetary economics, a 100% reserve policy would mean that the M1 money multiplier would never be more than 1. From the standpoint of central banking, it means that central-bank control of M1 would be much tighter than it already is. If the central bank wanted to increase M1 by $10 billion, all it would have to do is create $10 billion in added reserves in normal times. Fluctuations in the M1 money multiplier won't get in the way unless excess reserves build up.

Fortuitously, the Fed's decision to pay interest on reserves makes it feasible for the banks to eke out a small profit on their demand deposits under such a system. They need only pay the depositors a little less than what the Fed grants them. The margin would be very thin, 'tis true, but the deposits would be completely safe. That coverage would take a real load off the deposit-insurance system.

Moral Hazard Turned Inside Out

What's funny about the practicality of a limited 100% reserve policy is that it would be totally impractical had the Fed not been obliged to come to the rescue of the banking system. It was the Fed's response to the financial crisis that pushed reserves up to the level they're at now. The financial crisis came about because moral hazard was mixed in with "too big to fail." The American banking system, as a result, is now in a condition where "too big to fail" can be replaced – for demand deposits - with "too protected to implode."

There's even a populist element to it, a retributive aspect. In Canadianese: "That's what you get for threatening the financial system. One thing's for sure, you can learn to live on the crumbs and even like it. After what you pulled, a crumb with safety should look pretty good to you. The feast of fear hasn't worked out all that well for anyone." Note that the "crumbs" are only the margins on demand deposits. No other opportunities would be affected.

In fact, maybe they shouldn't. The way the Fed went about rescuing the banking system – using excess reserves as a needed bank-capital buttress – has set a precedent for official response to moral-hazard-induced financial collapses. What if another one comes along, necessitating the central bank to create (say) another trillion in reserves that turn out to be capital-buffering excess reserves?

A similar policy can be applied to time deposits. Currently in the United States, there are no reserve requirements on time deposits. It's almost certain that there'll never be enough rescue reserves created to make a 100%-reserve policy for time deposits practical, but it would be a propitious time to re-impose a reasonable reserve requirement on them. Time deposits are counted in M2. Required reserves on time deposits will create a tighter link between central bank reserve creation and the money supply.

With time deposits, a reserve policy faces another obstacle. By convention, interest is always paid on them. If the interest the Fed pays on reserves in insufficient to compensate, then time-deposit-taking banks will be put in a spot. There's a concept from the Canadian banking system that can ease that squeeze: "secondary reserves." Secondary reserves are highly liquid federal-government-issued securities. For time deposits, the banks could be granted the option of holding secondary reserves in a central-bank-held custodial account, from which the interest can be withdrawn but not the securities themselves unless there's an excess in the account. That way, the securities can earn the risk-free rate of return while still acting as demand-deposit reserves. This practice would leave crumbs too, but the spread would still be positive in normal circumstances. In order to earn an above-crumb return, the banks would be obliged to lend the other time-deposits out. Thus, incentives for loaning to the private sector would still exist. But, they wouldn't if a 100%-reserve policy was implemented: all the deposit money would have to be loaned to the government. So, a flat 100% reserve policy on time deposits would be insuperably restrictive.

The required-reserve securities could be sold and withdrawn only if needed to cover withdrawn time deposits. While this practice would not neuter bank runs, unless all quick-withdraw time deposits [not time deposits period] are covered by newly-minted rescue reserves, it would make depositors' money safe with far less risk to the deposit-insurance fund.

Radical, But Feasible

The times we live in are indeed strange when a truly radical policy – extremely radical, given postwar banking practice - is also feasible. The original proposal is an adaptation of Murray N. Rothbard's 100% Gold Dollar; the modification consists of keeping the present fiat-money standard. It's an odd world indeed where a policy deemed anathema in mainstream monetary economics can be implemented almost seamlessly in the aggregate.

The main obstruction, of course, is in the details. Just because reserves are above demand deposits in the aggregate doesn't mean that every member bank has enough to cover its own demand deposits. However, the ones that do are clearly the beneficiaries of the '08 and '09 bailouts. As the recent resurgence in bonuses suggests, these same institutions are likely to dip into the rescue system again. Given this overlap, there's some cause to impose a 100% reserve requirement on demand deposits in any bank that received the old Fed reserve assist.

Thus would begin a topsy-turvy world, one where hazard-ridden banks have 100% safe demand-deposit accounts and more prudent banks have only a fraction of that protection. If implemented, the Plain Joe of tomorrow might find it not quite to his common sense – 'tis true – but today's will understand perfectly.